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Summary of Selected Issues and Analytical Notes on Costa Rica

Core Content

This document provides an analysis of the implications of the new U.S. administration's economic policies on Costa Rica and the broader Central America region. It also examines fiscal and financial sector issues, as well as the impact of climate change and infrastructure bottlenecks on the country's competitiveness.

Main Exposures to U.S. Policies

• Trade Exposure: The U.S. is a major trading partner for Costa Rica, accounting for around 40% of total goods exports from Central America. Costa Rica's trade balance with the U.S. was a deficit of US$1.7 billion in 2016.
• FDI Exposure: FDI flows and stocks in North and Central America are heavily concentrated in Costa Rica and U.S. counterparts. The U.S. accounts for about 60% of Costa Rica's FDI stock, representing over 30% of GDP.
• Immigration and Remittances: These are not major channels for Costa Rica, as remittances account for less than 0.5% of GDP. Unlike other Central American countries, Costa Rica does not rely heavily on remittances.
• Financial Linkages: Costa Rica has stronger financial linkages with the U.S. compared to other Central American countries, making it more vulnerable to tighter external financial conditions.

Implications of U.S. Policy Changes

A. Potential Policy Changes in the U.S.

• Fiscal Policy: Expansionary fiscal policy, likely through tax cuts, could lead to higher U.S. economic growth, which would benefit Costa Rica through increased FDI and trade.
• Monetary Policy: A tighter monetary policy stance could result in higher global interest rates, increasing external funding costs for Costa Rica.
• Trade Policy: The U.S. may increase tariffs or modify trade agreements like NAFTA and CAFTA-DR, which could reduce export volumes and negatively impact trade balances.
• Migration Policy: More restrictive migration policies, such as increased deportations and potential remittance taxes, could reduce migration flows, which are not as significant for Costa Rica as for other countries in the region.

B. Effects on Costa Rica

• Positive Spillovers: Costa Rica could benefit from U.S. fiscal expansion and deregulation, leading to increased growth and investment.
• Negative Spillovers: Tighter U.S. monetary policy and trade protectionism could lead to higher funding costs and reduced export competitiveness.
• FDI Risk: A shift in U.S. corporate tax policy to a lower rate could lead to a reallocation of FDI flows away from Costa Rica, especially if the U.S. tax system becomes more favorable to domestic firms.

Key Findings from Estimations and Results

• GDP Impact: Model simulations suggest that U.S. policy changes could reduce Costa Rica's GDP growth by 0.5% over the medium term.
• FDI Reduction: A 20% reduction in U.S. FDI to Costa Rica could lead to a similar 0.5% GDP decline.
• Tariff Increase: If NAFTA or CAFTA-DR were repealed and tariffs raised to WTO MFN levels, Costa Rica's real exports could decline by 1–7% in the short run and 1–16% in the long run.
• Taxation Impact: The proposed U.S. tax reforms could have a more significant negative impact on Costa Rica due to its relatively low effective tax rates compared to other Central American countries.

Fiscal Sector Issues

A. Distributional Impact of Tax Reforms

• Income Inequality: Costa Rica has relatively high income inequality, especially before taxes and transfers. The Gini coefficient for Net Market Income (NMI) is around 0.51.
• Tax System: The current tax system in Costa Rica is biased toward indirect taxes, with sales tax and other indirect taxes contributing over 60% of total tax revenue.
• Proposed Reforms:
  • Main Proposal: Conversion of sales tax to VAT, inclusion of services, gradual increase in VAT rate to 15%, and introduction of targeted transfers for lower income brackets.
  • Alternative Proposal: No VAT rate increase, limited transfers to the bottom 30%, and lower marginal tax rates for higher income brackets.
• Impact on Inequality:
  • The main proposal would reduce inequality more significantly than the alternative.
  • The Gini coefficient for consumable income (CI) would increase slightly under both reform scenarios, but more under the main proposal.
• Poverty Impact:
  • Poverty and extreme poverty would increase slightly due to the VAT impact on lower income households.
  • Theoretical VAT refunds would largely offset these effects, assuming perfect targeting and full compliance.

Financial Sector Issues

• Credit Cycle and Capital Buffers: Costa Rica's credit cycle is influenced by U.S. monetary policy changes, and the country may face higher external funding costs.
• Banking Sector Vulnerabilities: Stress tests indicate that tighter U.S. monetary policy and higher risk premiums could lead to liquidity issues for the banking sector.
• Liquidity Buffers: Costa Rica's liquidity buffers are relatively weak, making it more vulnerable to external shocks.
• Spillovers from Stress: Spillovers from international bank stress could affect Costa Rica's financial stability.

Addressing Infrastructure Bottlenecks

• Competitiveness: Inadequate infrastructure is a key constraint on Costa Rica's competitiveness.
• Logistics Challenges: Poor infrastructure increases logistics costs and reduces export competitiveness.
• Public Investment Efficiency: Costa Rica needs to improve public investment efficiency to enhance infrastructure and logistics performance.

Climate Change and Environmental Policies

• Climate Change Impact: Climate change could have negative effects on growth, particularly in sectors vulnerable to environmental changes.
• Environmental Policies: Environmental policies in Costa Rica may have mixed effects on growth, depending on their implementation and the balance between environmental protection and economic development.
• Trade-Offs: There is a trade-off between environmental policies and economic growth, with the potential for both positive and negative impacts.

Conclusion

• U.S. Policy Uncertainty: The economic outlook for Costa Rica is affected by uncertainties in U.S. policies, particularly in tax, trade, and migration areas.
• FDI as Main Risk: The FDI channel is the primary risk for Costa Rica, but the country also faces risks from tighter global financial conditions and reduced trade.
• Fiscal Reforms: The proposed tax reforms could reduce inequality but may also increase poverty if not properly mitigated.
• Financial Integration: Costa Rica's financial integration with the U.S. makes it more vulnerable to external shocks compared to other Central American countries.

Key Information

• U.S. Fiscal Policy: Likely to involve tax cuts and a tighter monetary policy, increasing global interest rates.
• Trade Impact: Increased tariffs or changes in trade agreements could reduce Costa Rica's export volumes.
• FDI Impact: Lower U.S. corporate tax rates could lead to a reallocation of FDI flows away from Costa Rica.
• Tax System: Costa Rica's tax system is relatively regressive, with a strong reliance on indirect taxes.
• Fiscal Reforms: The main tax reform proposal would increase VAT rates and introduce targeted transfers, reducing inequality but possibly increasing poverty.
• Financial Sector: Costa Rica's financial sector is vulnerable to external shocks and may require countercyclical capital buffers and improved liquidity management.
• Infrastructure: Inadequate infrastructure limits competitiveness and logistics efficiency.
• Climate Change: Environmental policies may have trade-offs with economic growth, requiring careful implementation.

References

• Andrle, Michal and others, 2015, "The Flexible System of Global Models - FSGM", IMF Working Paper No. 15/64.
• Auguste, Sebastián, Mario Cuevas, and Osmel Manzano, 2015, "Partners or Creditors? Attracting Foreign Investment and Productive Development to Central America and Dominican Republic", IDB.
• OECD, 2016, "Taxation and Growth in Central America".